Stock Report: JPMorgan Chase & Co (JPM)

THE HEDGEYE EDGE

JPMorgan shares are currently trading with the most implied upside to fair value in our fair value model for money-center, super-regional and regional bank stocks. By our estimates, JPM shares have upside of 33% based on our regression of EVA (economic value added) – which looks at the spread between return on capital and cost of capital – and the current multiple to tangible book value. Over time, we have found that sizeable discounts and premiums mean revert toward fair value giving JPMorgan an embedded tailwind in 2014.

From a catalyst standpoint, we expect JPMorgan to be quieter in 2014 than in 2H12-2013. This should be good news. Beginning in April 2012, when the “London Whale” fiasco first surfaced, and running through year-end 2013 it has been a rare day when JPMorgan or its CEO Jamie Dimon hasn’t been on page 1 in an unenviable light. This amounts not just to bad PR. JPMorgan recognized $11.1 billion in total litigation expense and existing reserve draw-down in 2013 – the highest annual amount in its history, and almost double the prior peak. For comparison, Bank of America (BAC) saw its peak litigation year in 2011, and went on to see its shares rise 108% in value over the following year and shares are now trading ~197% vs. year-end 2011.

TIMESPAN

INTERMEDIATE TERM (TREND)(the next 3 months or more)

In the intermediate term we expect the slow but steady improvement in the economy to continue to exert upward pressure on the long end of the yield curve. Widening yield spreads will fuel a modest acceleration in top-line growth for JPMorgan. Higher net interest income is pure margin as it requires no additional expense.

LONG-TERM (TAIL)(the next 3 years or less)

Our longer-term expectation is that JPMorgan will finally get past its “annus horribilis” (horrible year) of 2013 and begin to again move in the right direction. As the news flow and litigation expense of settlements begins to marginally decline, the discount to fair value will reflate. Moreover, the company, as of 4Q13, has finally achieved 9.5% Basel III “fully-loaded” capital, which is the amount required under the new regulatory framework.

What this means is that finally the company can begin requesting permission from the Fed through the CCAR process to return larger amounts of internally-generated capital to shareholders through stepped up dividends and increased share buybacks. Over the coming 12-24 months this will add to the return potential already embedded in the company’s significant relative undervaluation.

ONE-YEAR TRAILING CHART

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01/24/14 03:01 PM EST

LIFE INSIDE THE BOX

Takeaway:We had the honor of penning the Early Look this morning and used the opportunity to highlight the complacency of DRI's current CEO.

“If we lack emotional intelligence, whenever stress rises the human brain switches to autopilot and has an inherent tendency to do more of the same, only harder. This, more often than not, is precisely the wrong approach in today’s world.”

- Robert K. Cooper PhD

Robert Cooper is a neuroscientist and strategic advisor to CEOs and many Fortune 500 companies. Taking on the work that Dr. Cooper requires is certainly not easy. According to Cooper, your brain is organized to reflect everything you know in your life. Or, in other words, your brain is a record and an artifact of your past.

Consistent with this line of thought, Cooper poses the following question: Does your environment control your thinking or does your thinking control your environment?

To help you ponder, we ask the following questions:

What does your daily routine look like?

Did you wake up today and hop out of bed on the same side?

Did you shut your alarm off with the same hand?

Did you go to the bathroom like you always do?

Did you shower and follow the same grooming routine?

Did you dress the way your coworkers expect you to dress?

Did you follow the same breakfast routine and do you get angry when the morning commute to work is just slightly off the normal pace?

I’m sure many of you will find that you often revert back to a routine in life you are comfortable with or, in Layman’s terms, the same-old, same-old life. This is considered living life inside your box and it is much more prevalent among us and our colleagues than we’d like to acknowledge.

Admittedly, this may be too much philosophical thinking for a Friday morning. But, the metaphor of switching to autopilot during rising levels of stress could be the norm for a CEO whose company you have invested hundreds of millions of dollars in and whose stock is underperforming. Isn’t this a scary thought? What if this routine keeps him/her in survival mode and prevents him/her from making the right decisions for the company he/she is running?

Back to the Global Macro Grind…

I often refer to this decision making process in the restaurant space as the “6 Stages of Grief.” This is a cycle that some companies tend to go through before they can see life outside the box. As I see it, today’s activist investors provide a version of neurological therapy for this grief.

Unfortunately, the news of an activist investor can actually provoke a series of decisions based on past experiences that might be inconsistent with what is appropriate for today’s environment. When an activist investor arrives on the scene, it’s only natural that “as stress rises, the human brain switches to autopilot and has an inherent tendency to do more of the same, only harder.”

Whether it’s a letter from Dan Loeb saying you’re an idiot or a letter that says “we look forward to maintaining an open dialogue and working with you to ensure that value is created for all shareholders,” either one could put management on the defensive and get them to react in ways that could potentially destroy shareholder value.

Sadly, this is precisely the path of destruction that the CEO of Darden Restaurants is headed down.

As I said earlier this week, the challenge for the Board members of Darden (or any Board) is to recognize the appropriate time to step up, break out of their box, and implement meaningful change. It is their challenge, their job, and their responsibility not to be more of the same.

When a Board works closely with a CEO for a number of years, the best interest of shareholders’ can become fuzzy. As an outsider, it appears that this is the case with the current Board and Chairman/CEO Clarence Otis. The operational performance of DRI has stagnated and it is, without question, time for a significant change.

As Keith said in yesterday’s Early Look, we are short a significant number of restaurant names. On yesterday’s earnings call, the CEO of Starbucks, Howard Schultz, went out of his way to emphasize the decline in bricks and mortar retailing. Starbucks was wisely in a position to win in this environment. Mr. Schultz is a great example of a CEO, at least in my space, that is willing to take on the difficult task of recognizing when and where he can strengthen his company.

To be honest, I welcome the commentary about bricks and mortar retailing as it relates to my short call on CAKE. My original thesis was shorter term, but his comments could make our bearish call on CAKE more secular in nature. In the short run, however, we believe the price spikes in the dairy complex are unaccounted for and suggest that EPS estimates are too aggressive for the company in 2014.

Moving on to a broader concept, the biggest risk to the consumer and restaurant space in 2014 is our MACRO theme of #InflationAccelerating. The CRB Index, milk, cheese, natural gas, cattle, hogs and coffee are all up more than the S&P 500, as gold continues to signal higher lows. With the Bloomberg Consumer Confidence Index flat week over week at -31, sluggish Per Capita Disposable Income, and a stagnant job market, it could be challenging for most companies to take price in order to offset inflation.

The irony of all this is that one of the few names I like on the long side is Darden Restaurants. The CEO’s tendency is to do more of the same, only harder. While I’m typically not a proponent of this line of action, it has indeed created a significant opportunity for a lot of money to be made.

It has also provided me with the material for a scathing attack on what has arguably been the largest case of value destruction in Casual Dining history. For the record, if you’re reading this Mr. Loeb, I have everything you could possibly need to write your best letter yet.

Across our core risk management durations here are the lines that matter to me most:

Immediate-term TRADE resistance = 1848

Immediate-term TRADE support = 1821

Intermediate-term TREND support = 1779

In other words, for the 1st time in months the SP500 is signaling A) lower-highs vs the all-time closing high and B) a very immediate-term TRADE momentum line breakdown with C) fundamentals (#GrowthSlowing) hanging out in the background.

Sure, there are plenty of reasons to buyem. Flows in particular are tantalizing. But a stock market that goes down on Down Dollar and Down Rates (today), is a stock market that is worried about something I haven’t had to worry about for a year now = #GrowthSlowing.

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What's New Today in Retail (1/24)

Last night Howard Schultz echoed our recent comments that this past holiday would prove to be a watershed moment for e-commerce:

"Holiday 2013 was the first in which many traditional bricks and mortar retailers experienced in-store foot traffic give way to online shopping in a major way. Customers researched, compared prices and then bought the brand and items they wanted online, frequently using a mobile device to do so. This was also the first holiday in which consumers embraced the convenience and flexibility afforded by physical and digital gift cards with a passion. Instead of gifting a particular item, many consumers instead chose to give the gift of choice."

From Our Note on January 9th:Takeaway: With all the companies putting up disappointing sales, we wanted to throw out a factor that we think is critical. Yes, weather was terrible as the month closed out (and got worse in January). But one thing we'll keep in mind is our view that this holiday will go down as a watershed year for the shift from bricks and mortar to dot.com. The chart below shows that over the past 10 years there has been a steady increase in e-commerce's share of total spending, but we think that when this quarter's numbers are reported, it will show the greatest increase in the slope in the history of the internet. Our belief is that shopping is behavioral, and an increase in dot.com will only feed upon itself and continue to gain share in 2014.

"Team USA's opening ceremony uniforms for the Sochi Olympics are a patchwork of American iconography — of oversized stars and stripes and multicolored rings and names and numbers."

"They're also a patchwork of American craftsmanship — of wool carted from Oregon, spun in Pennsylvania and North Carolina, and knit in California."

Takeaway: No surprise that RL is making a big deal about these uniforms being 'a patchwork of American craftmanship'. It's still reeling from the PR headache of putting uniforms on athletes in 2012 that were made in China. You may or may not like the uniforms below, but there's no mistaking what country they represent.

"The Home Depot...today announced that it has acquired Blinds.com. Based in Houston, Blinds.com is the #1 online window coverings retailer in the world. The acquisition closed today, and terms of the deal were not disclosed."

Takeaway: This makes sense for The Depot, as it's been trying to build out more on the home furnishings side as opposed to the home renovation side. But we're surprised to see HD deploy capital in online blinds. There are a lot of categories that lend themselves perfectly to the online marketplace. But we don't think blinds is one of them. We're not saying it's a bad deal. But for a company that so rarely acquires other businesses, we're just a little surprised about this one.

"Neiman Marcus Group Ltd., the luxury retailer, said about 1.1 million credit cards may have been compromised in a data breach that occurred last year."

Takeaway: At least it's not 40 million. Our sense is that the average Neiman customer is still shopping there come hell or high water -- even with a data breach. On the other hand, Target customers will much more easily shift to other alternatives -- because there are alternatives. Not quite the case with Neiman.

"Wal-Mart Stores Inc. has responded to a critical report on Chinese state-run television this week, assuring that it does not cut corners in safety checking or approving products for sale at its 400-plus stores in China."

"The company released a detailed statement on Friday in response to a story that appeared on state broadcaster CCTV Thursday evening accusing Wal-Mart of circumventing China’s retail product permit procedures for profit. The report said Wal-Mart had violated proper procedures in instances of more than 600 products that went to its shelves."

Takeaway: Wal-Mart is doing everything in can here. But the reality is that when a Chinese State-run TV station sets its sights on you, even the best PR response is probably not enough.

"To promote her new shoe line, SJP, Sarah Jessica Parker is teaming up with Nordstrom for a series of pop-up shops at select stores nationwide. The multicity tour kicks off Feb. 28, coinciding with the line’s official launch date."

"Through March 2, Parker will be on hand at Nordstrom’s Treasure & Bond location in SoHo to sell shoes, greet fans and sign the product. Following her New York stint, Parker will be making personal appearances from March 5 to 9 at Nordstrom locations in Seattle, Los Angeles, Chicago, Miami and Dallas, respectively."

Takeaway: Sex and the City has been off the air for a decade now…we must have missed the memo that Sarah Jessica Parker is still relevant.

"Patagonia on Thursday appointed Rose Marcario, chief executive officer of Patagonia Works, the parent company of Patagonia, Inc., to the dual post of president and ceo of Patagonia. Prior to serving as the ceo of Patagonia Works, Marcario served as Patagonia’s chief operating officer and chief financial officer. Casey Sheahan will step down as ceo of Patagonia, Inc., effective Feb. 7, in order to spend more time with his family in Colorado."

"Craig Nomura has been appointed president of global retail at Levi Strauss & Co., effective Feb. 3."

"Nomura, most recently senior vice president of global development at Williams-Sonoma Inc., will also serve as executive vice president of the San Francisco-based jeans and sportswear firm and report to Chip Bergh, president and chief executive officer."

"He succeeds Joelle Maher, who left Levi’s in June to join Gymboree Corp. as chief operating officer."

"SAP AG announces plans to collaborate with key customers to better meet the challenges faced by apparel, footwear and accessory companies. Working with adidas, Luxottica and Tommy Hilfiger, SAP envisions bringing a new fashion solution to the marketplace that will better enable fashion brands to manufacture their products and sell them to retailers and consumers using one single, vertical solution."

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01/24/14 09:18 AM EST

YES IGT THE DEC DOWNTURN WAS PREDICTABLE

While we didn't expect such a big FQ1 miss, we correctly predicted the September and December downturn in regional gaming revs. There is more contributing to IGT's woes, however.

"I don't know anyone who wasn't surprised by the December results..." – John Vandemore, IGT CFO

Sorry, John but Hedgeye predicted both the September and December downturns within 1% of actual YoY growth. Check our research on hedgyeye.com. It was simply the math in our model. The chart below shows our monthly projections for 2013 along with the actual YoY growth.

IGT punted FQ1 and gave qualitative guidance that looks even worse than the low end of their previous 2014 range. Management blames sickly regional gaming revenue and its impact on IGT’s yields but the problems are deeper. Yes, the casinos are facing declining demand from slot players but IGT is losing share in gaming operations, ASP’s are under pressure, and 20% annual declines in North American slot demand over the next two years will be tough to overcome.

We turned negative on IGT in our 10/10/13 Black Book “SLOThy GROWTH” (we also attached a video link below). In fairness, we did not expect a 5c miss in Q1 despite getting the December GGR analysis right. IGT usually can pull a few levers to make the quarter, although for the 2nd quarter in a row, they couldn’t. IGT’s full year FY2014 guidance always looked high and management finally confirmed that.

So where does IGT go from here? With the stock clearly underperforming in Q4 and in January – IGT is indicating down another 10% pre-market – it looks pretty washed out. Even with the bad weather, our model is actually projecting a rebound in regional GGR in January – still down low single digits but an improvement over December’s -10%. Is that a reason enough to buy the stock? No, but the next negative catalyst may be a few months off.

While IGT faces 2 years of negative headwinds, we’ve often thought the company should be private and that possibility remains. Strong free cash flow, a low valuation, strong balance sheet, and limited capex needs still hold. Remember that private equity was interested in WMS and one firm actually made it to the final round of the bidding process. IGT’s size is more suitable for private equity and unlike WMS, generates a lot of free cash flow.

With all that said, the risk/reward looks about equal after the open today.

Get the Macro Right!

Client Talking Points

#GrowthDivergences

Looking to the U.S., Europe, China and Japan, we see the heavyweights of the world economy diverging from an economic growth perspective as some countries and/or regions are much further along in the economic cycle than others. This has implications for investors around the globe. Country/sector/asset picking matters in a lower variance, divergent performance environment. Some big YTD divergence and the YTD is only a few weeks old.

#FlowShows

We expect a continuation of fund flows out of fixed income and into equities during Q1. The “Queen Mary” has indeed turned, aided by the Fed’s decision to begin tapering. According to the latest ICI Fund Flow Survey, Equity flows perked up strongly after a negative week to start '14 with the biggest inflow in 10 weeks. This strong weekly inflow coupled with the slight outflow from last week has now moved the 2014 weekly average to a $3.9 billion average inflow for equities to start 2014, a follow through on 2013's positive trends where $3.0 billion per week on average flowed into stock funds.

#InflationAccelerating

Across the globe, reported inflation readings are poised to accelerate from post-crisis lows as easy comps, a commodity base effect and accelerating wage pressures all come to a head in the first quarter of 2014. The reemergence of inflation as a core macro risk threatens to materially alter the investment landscape going forward.

Asset Allocation

CASH

33%

US EQUITIES

15%

INTL EQUITIES

18%

COMMODITIES

9%

FIXED INCOME

0%

INTL CURRENCIES

25%

Top Long Ideas

Company

Ticker

Sector

Duration

FXB

We remain bullish on the British Pound versus the US Dollar, a position supported over the intermediate term TREND by prudent management of interest rate policy from Mark Carney at the BOE (oriented towards hiking rather than cutting as conditions improve) and the Bank maintaining its existing asset purchase program (QE). UK high frequency data continues to offer evidence of emergent strength in the economy, and in many cases the data is outperforming that of its western European peers, which should provide further strength to the currency. In short, we believe a strengthening UK economy coupled with the comparative hawkishness of the BOE (vs. Yellen et al.) will further perpetuate #StrongPound over the intermediate term.

DRI

Darden is the world’s largest full service restaurant company. The company operates +2000 restaurants in the U.S. and Canada, including Olive Garden, Red Lobster, LongHorn and Capital Grille. Management has been under a firestorm of criticism for poor performance. Hedgeye's Howard Penney has been at the forefront of this activist movement since early 2013, when he first identified the potential for unleashing significant value creation for Darden shareholders. Less than a year later, it looks like Penney’s plan is coming to fruition. Penney (who thinks DRI is grossly mismanaged and in need of a major overhaul) believes activists will drive material change at Darden. This would obviously be extremely bullish for shareholders and could happen fairly soon driving shares materially higher.

GHL

Hedgeye's detailed and constructive view on the improving fundamentals in the M&A market with a longer term perspective is a contrarian idea at odds with the rest of the Street which is overly focused on short-term results. From an intermediate term perspective, M&A is poised to break out in 2014. We are witnessing record amounts of cash on corporate balance sheets, continued low borrowing costs and the first positive fund raising round for Private Equity in four years. Moreover, a VIX in secular decline (this has historically benefited M&A), recent incrementally positive data points from leading M&A firms that dialogue has improved, and an improving deal tally from Greenhill & Company (GHL) themselves coming out of the summer all bode favorably for GHL. So is a budding European economic recovery that would assist a global M&A market that has been range bound over the past three years. GHL stands out as a leading beneficiary of these developments.

Three for the Road

TWEET OF THE DAY

Markets aren't about calling tops and bottoms - they are all about risk managing ranges @KeithMcCullough

QUOTE OF THE DAY

"It's not that I'm so smart, it's just that I stay with problems longer."

-Albert Einstein

STAT OF THE DAY

Treasury prices surged Friday in their second day of strong gains. The 10-year note was down 5 basis points at 2.722%, on track for its lowest close since the end of November.

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